A paradigm shift in financial markets has taken place since 2008 into a more volatile investment environment that will demand different ways of managing risk. In an ironic twist of intention, today’s higher volatility is the consequence of attempts by central banks to engineer a less volatile economic environment. This environment, one in which recessions are shorter/shallower and expansions stronger/ longer than they were in the early part of the 20th century, has its roots in the early 1980s and has spanned over two decades (read about it our “Blue” Paper titled, Living in a More Volatile Investment World.)

Dubbed “the Great Moderation” this period commenced with the resetting of inflation expectations by Fed Chairman Volker through his attempts to break the back of inflation by a focus on money supply. In addition, the trend toward globalization helped defuse inflationary influences (as overseas capacity robbed firms of pricing power, and were a “relief valve” for domestic price pressures). The decline in inflation and inflation volatility helped support a prolonged decline in interest rates.

The “Paradox of Credibility”

Improved corporate balance sheets, more transparent monetary policy, and new “riskdiversifying” financial instruments also lowered the perceived riskiness of investing in securities tied to economic growth. Unfortunately, the stable macroeconomic environment and strong central bank credibility created a false sense of security. Hyman Minsky dubbed this the “paradox of credibility.” The Great Moderation era led to excessive credit expansion and an underpricing of risk. Valuation bubbles and excess debt were the consequence, manifesting three times since the early 1990s in both the U.S. equity and two real-estate busts.